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Contractor Loans – What are the risks?


For decades now contractors have been approached with tax schemes involving loans. In essence these schemes involve describing a part of the contractor’s income as a loan, rather than taxable salaries or dividends, supposedly saving thousands of pounds in tax. The problem these schemes share is that the Revenue favours substance over form. It doesn’t matter if you call income a loan, they will look at the substance of it – will you ever actually repay it? Have you received it as a result of your work? Usually it is hard to justify these schemes once the taxman starts asking questions; why for instance would you accept a salary often as low as £15,000 a year for a role that usually pays hundreds of pounds a day? It is hard to find an answer that would satisfy a tax tribunal.

Over recent years we have seen scheme after scheme unravel as a succession of anti-avoidance moves by HMRC have proved successful. The Revenue’s latest tool, an overarching tax charge on historic loan income to be paid in 2019, puts loan schemes in their worst position yet. So what are these schemes and what risks do they bring?

Employee Benefit Trusts (EBTs)

Once common both for contractors and for high-paid employees in fields such as finance, an EBT setup involves an employer (or umbrella company) paying the employee modest salary, with the rest of their remuneration paid into a trust. The trust would then arrange for loans to the individual or their family members. In 2011 Part 7a of the Income Tax Act (ITEPA) defined this process as “disguised remuneration” and made the loans taxable.

Self-Employment Benefit Trusts

The spiritual successor to the EBT, these sidestepped Part 7a by not involving an employment relationship. A contractor would work through their own limited company and take on a contract. They would then subcontract the work to a company based in an offshore tax haven, usually the Isle of Man, before being taken on in a self-employed capacity by that company, and assigned to their original contract. They would receive a minimal payment for this task, with the offshore company arranging for a loan from a trust for the rest of their remuneration. In 2017 the definition of disguised remuneration in Part 7a was extended to include self-employment and partnership relationships.

Company loans

In this setup rather than receiving a loan from a trust the loan comes directly from a company, usually based offshore. Many providers started selling this type of loan scheme because of negative publicity around trust planning. In some cases the company providing the loan is the contractor’s umbrella employer, but more normally it is a third party. For contractors using a limited company this arrangement typically involves the company being billed for “offshore services” or some other vague service, and then the loan being arranged by the company that is paid.

Commercial Trust Loan Schemes

This scheme sees a contractor working and invoicing though their own limited company. Rather than taking all of the profits as salary or a dividend, they instead contribute a large portion of it to a trust. Because this is done ostensibly for some commercial purpose, typically to improve relations with the company’s clients and suppliers, it is classed as an expense on the company’s accounts. The suppliers and clients don’t see a penny however, instead the contractor, who is also a beneficiary of the trust, takes a loan. Usually repayment never happens and the loan is either written off or automatically rolled over. HMRC describe these schemes as “highly contrived” and say that they plan to challenge them

A Loan by Any Other Name…

As HMRC began to close in on loan schemes, some providers began to dress up the same old scheme as something else. Most notable are a range of product that involve annuities. These work in exactly the same way as the company loan schemes, except that rather than a loan the second payment received from the supplier is described as payment for an annuity (similar to a pension) that the contractor will supposedly pay the supplier at an unstated point in the future. What makes annuity schemes notable is that it took just a few weeks from their coming on to the market for HMRC to issue a Spotlight on Tax Avoidance declaring that they consider the “annuity” payment to be a loan and will challenge them as a loan scheme. The same suppliers are now often describing the payment as an option payment. Since these schemes operate in exactly the same way as annuity schemes, there is no reason to think that the Revenue will see them any differently.

Whatever type of loan scheme you use the main risks are the same.

Part 7a – Disguised Remuneration

If the loan scheme that you use is found to involve the re-direction of your income into a loan through either an employment or self-employment relationship, this is defined by Part 7a of ITEPA as “disguised remuneration”. Having been identified under this rule, your loan can be subjected to tax as though it was a salary. The rules even allow HMRC to issue an Accelerated Payment Notice (APN) which requires you to pay the tax they say is owed before any tribunal or court action – you are guilty until proven innocent.

GAAR – The General Anti-Abuse Rule

Even if your loan scheme is not covered by Part 7a, you are still vulnerable to the Revenue defining it as income. The General Anti-Abuse Rule, known as GAAR, allows an HMRC-friendly panel to rule on whether a scheme gives a tax advantage that wasn’t intended or involves taking actions only in order to avoid tax. If they find that it does then they can issue a “GAAR Counteraction Notice”. This notice allows them to define the loans you received as income and subject them to Income Tax and National Insurance. Worse, under GAAR they can also add a penalty of up to 100% of the tax avoided – so you end up paying double tax!

The 2019 Loan Charge

Even if your loan scheme has escaped Part 7a and GAAR, there’s still bad news. 2017’s Finance act contained legislation that will see a huge retroactive tax bill for many contractors in 2019. Under these rules the amount of any loan taken since 1999 and connected to your employment, self-employment or being a director of a company, will be added to your taxable income for 2018/19, unless you have repaid the loan or already paid tax on the amount. This will mean a hugely inflated income – and so a hugely inflated tax bill, for many contractors who use loan schemes.

Further taxes on written-off loans

If your scheme involved the loan being written-off or discharged, then you may have to pay further taxes, especially if a trust is involved. This is usually in the form of Inheritance Tax, since this is how funds from a trust are treated, and applies even if you have paid income tax on the loans through an APN or the 2019 Loan Charge.

Demands for Repayment

Contractor loan schemes work on a nod and a wink – everyone involved knows that the loan will never be repaid. The danger for the contractor though is that all of the paperwork says that it is a genuine loan. Assurances from the lender that repayment will not be required will come to very little if a loan is not rolled over, and you would be left needing to find a large amount of money to repay. Those whose loans are issued by a company rather than a trust are especially at risk, since a trust setup offers some protection to its beneficiaries, and a trust cannot go bankrupt. If your loan came from a company, then the outstanding amount is an asset on the company’s books. In the event that the lender goes into liquidation, one of the first things the receiver will do to recoup money is to call in all outstanding debts – leaving you in the lurch.

Damage to your Reputation

Even if your contractor loan scheme avoids the attentions of HMRC, and the 2019 Loan Charge, and you can trust the provider not to recall the loan there is a risk that by using these schemes you become tainted in the eyes of clients and colleagues. HMRC’s recent successes against various loan schemes have been accompanied by a lot of news stories. In a world where corporations are very aware of their image, many are now looking into the finances of contractors before engaging them. In most cases the mere mention of the word loan will lead them to the conclusion that you are involved in tax avoidance of a sort that they want no connection with. Your friends and family, having read about these schemes in the papers are likely to take a similar view. Before using a contractor loan scheme, ask yourself if you can afford it, and how valuable your reputation is to you.